Goldman Says They Don't Benefit From A Too Big To Fail Funding Advantage

Goldman Sachs wants you to believe that Too Big To Fail banks do
not actually enjoy a funding advantage.

The Wall Street firm recently put out a paper with the mild
title of "Measuring the TBTF effect on
bond pricing." It argues that the commonly-held view that
TBTF banks can borrow cheaply because bond investors expect the
government will support them used to be a little bit correct.
Then it became very correct during the financial crisis. But now
is totally incorrect.

The study argues that that six banks with more than $500
billion in assets paid interest rates on their bonds that were an
average six basis-points lower than smaller banks from 1999 to
mid-2007. When the financial crisis struck, the funding advantage
grew far wider. But beginning in 2011, the funding difference
reversed, with the biggest banks now paying an average of 10
basis points more than smaller banks.

"This undermines the notion that government support drives
a TBTF funding advantage," the report says.

Well, not exactly.

CNBC.com

The Goldman researchers are practicing a bit of sleight-of-hand
here. The argument about TBTF funding has never been predicated
on the absolute funding levels of banks or the funding of big
banks relative to small banks. Rather, it's that the expectation
of government support lowers the cost of funds relative to what
they would be otherwise.

To put it more simply, the TBTF funding argument is that
Goldman, with implicit government support, pays less to issue
bonds than Goldman without support would.

Reading the Goldman report, you might come away thinking
that the principle difference between Goldman—or JPMorgan Chase, Bank of America, Citigroup,Wells
Fargo and Morgan Stanley—on the one hand,
and the smaller banks was simply size. But that's not true. The
TBTF banks take on far more risk and far more debt than smaller
banks.

Take UnionBanCal, the San Francisco subsidiary bank of the
Mitsubishi UFJ Financial Group. It is a big bank with around $97
billion in assets. But Goldman, with $938 billion in total
assets, is ten times the size. At the end of the last quarter,
Union had a tangible common equity ratio of 10.5 percent;
Goldman's was 6.95 percent. This means that where Goldman could
be rendered insolvent by a 7 percent drop in the value of its
assets, it would take a drop of greater than 10.5 percent for
Union shareholders to be wiped out.

This example is a pretty good illustration of the
difference between smaller banks and the TBTF variety. The
average smaller bank has a tangible common equity ratio of
between 9 percent and 10 percent. None of the six TBTFers has a
tangible common equity ratio greater than 7 percent.

This should matter for bond investors. A 2009 McKinsey
study found that one quarter of all banks with a tangible common
equity ratios of less than 7.5 percent were distressed during the
financial crisis, making up 83 percent of all distressed
banks.

But, as the Goldman study shows, these risky, debt-laden
banks pay only 10 basis point more on their debt
post-crisis.

In other words, there is a TBTF subsidy. It's not as large
as it once was, probably because the financial crisis made it
clear that the largest financial institutions are far more
fragile than almost anyone suspected prior to 2008. But it's
there and plain enough to see.

It's a bit disturbing that Goldman doesn't seem to
understand this. Their misperception means that they are likely
to misread or ignore market signals about the risks they take.
Goldman—and the other TBTF banks—seem to still be blind to their
own vulnerability—which is what got us in the financial crisis
mess in the first place.